Weathering the storm: An opportunity in Australian Insurance

Weathering the storm: An opportunity in Australian Insurance

Scott Olsson, Analyst

The hail storm that hit Sydney late last year made a lot of headlines, but has not changed our fundamental view that insurance is an attractive sector in the current environment. Losses from weather events are part and parcel of running an insurance business. While they introduce profit volatility and can have some flow-on impacts, we believe the major insurers are in a strong position to mitigate and offset these factors.

Sydney hail storm one of the biggest events of the past 30 years

The Insurance Council of Australia’s latest estimate is that this event will cost the insurance industry $673m. Our analysis suggests the cost could eventually reach $1.5-2.0bn once all claims are reported and paid, which would make it one of the top five most expensive weather events of the past 30 years and possibly the most damaging hail storm since the Sydney hail storm in 1999.

Source: Insurance Council of Australia, Firetrail Investments. Notes (1) Red bar indicates Firetrail estimate of ultimate losses from Dec-18 Sydney hail storm. Most recent estimate from Insurance Council of Australia is $673m.

Direct impacts are quantifiable and contained 

With 60-70% combined share of the NSW Motor and Home markets, at face value such an event could be disastrous for IAG’s and Suncorp’s FY19 profits. Both however, have very strong levels of protection which restrict losses and pass the excess on to reinsurers. The net costs of this event are capped at $169m for IAG and $250m for Suncorp, despite the gross cost likely being multiples of this amount.

Both insurers also have allowances in their guidance for a “normal” level of total weather losses in any given year. While the Sydney event does increase the chance that IAG and Suncorp exceed these allowances in FY19, both also have covers in place that provide protection if claims from multiple weather events over a 12-month period begin to add up.

The combination of various reinsurance protections mitigates a substantial proportion of the direct costs of the hail storm. We believe indirect impacts are more relevant for ongoing profitability.

Price lever can be pulled to offset indirect impacts

Apart from the actual claims from large weather events, there are two main flow-on impacts that need to be considered:

Increases in reinsurance costs

The price IAG and Suncorp pay for reinsurance would normally be expected to rise following large claim events, but over the years both have shown a strong ability to negotiate reasonably attractive terms. Most recently, IAG renewed its reinsurance program for 2019 at “relatively flat” rates, despite incurring losses on its 2018 program.

The ability of IAG and Suncorp to obtain favourable terms can be attributed to the significant surplus capacity that exists in global reinsurance markets, IAG’s and Suncorp’s position as two of the largest reinsurance purchasers in the world, and the attractiveness of Australia as a source of diversification for global reinsurers.

Supply chain pressures

The high number of repairs needed in a short space of time after a weather event can place insurer supply chains under strain. Following a hail storm, motor repairer capacity typically becomes stretched and costs are pushed higher. While any claims blow-outs from the hail storm should be covered by reinsurers, it is inflation in the day-to-day claims over the following six months that can put pressure on IAG and Suncorp.

Industry-wide impacts lead to re-pricing 

The indirect impacts from higher reinsurance costs and supply chain inflation tend to affect all insurers, which typically drives a pricing response across the industry (albeit sometimes with a lag). Following a run of large weather events in 2010/11, Home & Contents pricing increased by 10%+ pa for 3-4 years. Given reasonably rational Motor and Home markets currently, we believe there is a case for recent price increases to continue or perhaps accelerate.

Source: Insurance Council of Australia

Shelter from housing and consumer weakness

Stepping back from the noise of weather claims, one storm that insurers are well positioned to navigate is the current weakness in the housing market and Aussie consumer. While affordability pressures can have some impact, demand tends to be reasonably resilient given the nature of insurance products as mitigants of cash flow and asset risk.

Insurers have typically outperformed relative to the ASX200 during more bearish periods for markets and/or the economy. The chart below highlights how IAG and the ASX200 performed through the GFC. While the GFC is an extreme example, it illustrates the value the market places on the defensiveness of insurance in tougher times. We believe this is an attractive feature against the current consumer backdrop.

Source: FactSet, Firetrail Investments

Summary

The risk insurers face from large weather events will always be a key talking point for investors, but IAG and Suncorp have shown an ability to successfully mitigate a large portion of the P&L and capital volatility through reinsurance and re-pricing. With defensive characteristics in an increasingly difficult economic environment, we believe domestic insurance represents an attractive sector to be exposed to.

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Firetrail Investments Pty Limited ABN 98 622 377 913 (‘Firetrail’), Corporate Authorised Representative (No. 1261372) of Pinnacle Investment Management Limited ABN 66 109 659 109 AFSL 322140.

Any opinions or forecasts reflect the judgment and assumptions of Firetrail and its representatives on the basis of information at the date of publication and may later change without notice. Any projections contained in this article are estimates only and may not be realised in the future.  The information is not intended as a securities recommendation or statement of opinion intended to influence a person or persons in making a decision in relation to investment. This communication is for general information only. It has been prepared without taking account of any person’s objectives, financial situation or needs. Any persons relying on this information should obtain professional advice relevant to their particular circumstances, needs and investment objectives. Past performance is not a reliable indicator of future performance.

Interests in the Firetrail Absolute Return Fund (ARSN 624 135 879) and Firetrail Australian High Conviction Fund (ARSN 624 136 045) (‘Funds’) are issued by Pinnacle Fund Services Limited ABN 29 082 494 362 AFSL 238371. Pinnacle Fund Services Limited is not licensed to provide financial product advice. A copy of the most recent Product Disclosure Statement (‘PDS’) of the Funds can be located at www.firetrailinvest.com  You should consider the current PDS in its entirety and consult your financial adviser before making an investment decision.

Pinnacle Fund Services Limited and Firetrail believe the information contained in this communication is reliable, however its accuracy, reliability or completeness is not guaranteed and persons relying on this information do so at their own risk. Subject to any liability which cannot be excluded under the relevant laws, Firetrail and Pinnacle Fund Services Limited disclaim all liability to any person relying on the information contained in this communication in respect of any loss or damage (including consequential loss or damage), however caused, which may be suffered or arise directly or indirectly in respect of such information.

Our #1 stock pick for 2019

Our #1 stock pick for 2019

Blake Henricks, Deputy Managing Director & Portfolio Manager

Nufarm is an Australian company that specialises in chemical crop protection globally. It produces products to help farmers protect their crops against damage caused by weeds, pests and disease.

There are two key reasons we believe Nufarm is one of the most compelling opportunities in the Australian equity market today:

  1. Industry consolidation
  2. Omega 3 opportunity

This article explains why Nufarm is undervalued today and why we believe it will be a future winner for our investors over the medium term.

Why Nufarm is undervalued

If you invested in Nufarm at the start of the year it has been a tough investment. The share price has fallen almost 30% and Nufarm is trading at a substantial discount to its global peers.

The underperformance has been driven by two key issues:

  1. Australian drought – The Australian drought in 2018 significantly impacted Nufarm’s Australian earnings (~15% of total company earnings). The drought was a one in fifty year event. But investors need to remind themselves that droughts are cyclical in nature. They are not structural issues and whilst we do not know when it will rain, we like to take the contrarian approach of buying in drought and selling in rain.
  1. Glyphosate concerns – Glyphosate is the world’s most commonly used herbicide. It has come under controversy this year following a US law suit against Monsanto, which ruled that ‘RoundUp’ (which contains glyphosate) caused a former school gardener’s cancer. Glyphosate products currently account for almost 20% of Nufarm’s earnings so this is an issue we are monitoring closely. To date there are no glyphosate cases against Nufarm.

Whilst controversial, we don’t believe there is any reasonable scenario where chemical crop protection is banned globally. Doing so could reduce global crop yields by 40% which would result in a global food shortage. The issue is multi-faceted, but we believe Nufarm is well-placed in any reasonable outcome from the controversy.

The Australian drought and glyphosate concerns have created a buying opportunity for medium to long term investors. Below we explain why we believe Nufarm will be a future winner for our investors.

Industry consolidation

The Global crop protection market is a US$50bn industry. The industry has traditionally been dominated by six large players including multinational brands such as Bayer, Syngenta, Monsanto and BASF. However, the crop protection industry has been going through a major period of consolidation over the past two years. Since 2016, the six largest players have consolidated to four.

Nufarm is a big beneficiary from industry consolidation. Less competition means a better pricing environment across the market. In addition, the frenzy of mergers and acquisitions across the industry has resulted in forced asset sales, giving Nufarm a once in a lifetime opportunity to buy high quality assets directly from competitors at great prices. With competitors distracted and internally focused, we believe Nufarm has an opportunity to gain market share as a focused, independent alternative supplier of crop protection to its customers.

Omega-3 opportunity

Fish oil is a rich source of Omega-3 fatty acids. It is derived from sustainably caught unpalatable fish such as anchovies and other fish by-products and used predominantly as aquaculture feed in fish farms. Omega-3 is required to meet the world’s growing appetite for fish. However, as Chart 1 highlights, the world is short natural sources of Omega-3.

Source: Firetrail

Nufarm has developed the World’s first plant-based source of Omega-3 in partnership with the CSIRO.  Whilst there are competitive technologies being developed, Nufarm will be first to market, with patents beyond 2030 and regulatory approval for commercialisation expected in 2019.

In our view, the Omega-3 opportunity represents 40% additional upside to the current share price despite earning nothing today.

Conclusion

Nufarm has fallen over 30% this year and is currently undervalued versus its global peers. Whilst there are issues regarding the Australian drought and glyphosate concerns, we believe there is material upside to today’s share price. In our view, industry consolidation and the Omega-3 opportunity will provide significant earnings growth for the company. We believe Nufarm is one of the most compelling investment opportunities in the share market today.

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Firetrail Investments Pty Limited ABN 98 622 377 913 (‘Firetrail’), Corporate Authorised Representative (No. 1261372) of Pinnacle Investment Management Limited ABN 66 109 659 109 AFSL 322140.

Any opinions or forecasts reflect the judgment and assumptions of Firetrail and its representatives on the basis of information at the date of publication and may later change without notice. Any projections contained in this article are estimates only and may not be realised in the future.  The information is not intended as a securities recommendation or statement of opinion intended to influence a person or persons in making a decision in relation to investment. This communication is for general information only. It has been prepared without taking account of any person’s objectives, financial situation or needs. Any persons relying on this information should obtain professional advice relevant to their particular circumstances, needs and investment objectives. Past performance is not a reliable indicator of future performance.

Interests in the Firetrail Absolute Return Fund (ARSN 624 135 879) and Firetrail Australian High Conviction Fund (ARSN 624 136 045) (‘Funds’) are issued by Pinnacle Fund Services Limited ABN 29 082 494 362 AFSL 238371. Pinnacle Fund Services Limited is not licensed to provide financial product advice. A copy of the most recent Product Disclosure Statement (‘PDS’) of the Funds can be located at www.firetrailinvest.com  You should consider the current PDS in its entirety and consult your financial adviser before making an investment decision.

Pinnacle Fund Services Limited and Firetrail believe the information contained in this communication is reliable, however its accuracy, reliability or completeness is not guaranteed and persons relying on this information do so at their own risk. Subject to any liability which cannot be excluded under the relevant laws, Firetrail and Pinnacle Fund Services Limited disclaim all liability to any person relying on the information contained in this communication in respect of any loss or damage (including consequential loss or damage), however caused, which may be suffered or arise directly or indirectly in respect of such information.

Raw material inflation: Picking the winners and losers

Raw material inflation: Picking the winners and losers

Patrick Hodgens, Managing Director & Portfolio Manager

Costs are rising. Raw material inflation is coming through the supply-chain across industrial stocks. As a result, earnings pressures are emerging in many companies with exposure to raw materials. We have seen this in companies with exposure to oil (such as transportation, rubber or plastics) and pulp (i.e. Paper and building materials). Share prices have fallen as a result of downgraded earnings.

This article takes a closer look at some of the companies impacted by rising raw material costs, as well as where we are seeing the risks and opportunities. We conclude that now may be the time to invest in companies that have been oversold due to cost inflation concerns, particularly those that are able to pass rising costs through to their customers.

The losers

The Australian equity market has seen a number of companies downgrade FY19 earnings due to rising raw material costs. In October, James Hardie downgraded earnings after reporting 2Q19 results. FY19 profit guidance was reduced by approximately 6% citing increases in key input costs such as pulp, freight and cement. The share price subsequently declined 15%.

In our view, the James Hardie share price decline is an opportunity to buy a high-quality business, with solid growth, at a compelling valuation. Over the medium-term, we expect input costs to revert, while James Hardie should be able to deliver strong earnings growth underpinned by high single digit revenue growth through a combination of market and share growth in the US housing market.

Ansell is another company negatively impacted by rising raw material costs. Ansell manufactures and sells gloves and other protective rubber and latex products in the healthcare and industrial sectors. The key raw material inputs for Ansell are highlighted in Chart 1.

Rising raw material costs are a major headwind for Ansell’s earnings. Key raw material inputs including Fibres and Yarns (for example, Cotton) and Nitrile Latex have seen significant price rises over the year, up 13% and 27% respectively. In August, the company’s management downgraded FY19 earnings guidance by approximately 7%, resulting in a 9% fall in the share price. The Ansell downgrade highlights the impact higher raw material prices can have on profit margins, particularly for companies unable to increase prices and pass these costs onto their customers.

Chart 1 – Ansell Raw Material Input Costs (% FY18)

Source: Company data

What happens next? Picking the future winners

Some companies are better placed than others. There are companies in favourable industry structures that are able to pass rising costs onto their customers. Below we highlight two companies that we believe meet the above criteria.

Qantas Airways

Since July 2018, Qantas has fallen by approximately 11% on the back of rising cost concerns, in particular higher oil prices. There is no doubt that higher oil prices impact Qantas’ earnings. However, what makes Qantas unique is its ability to pass these higher costs through to customers. Over the past year, we estimate Qantas has increased its domestic airfares by 7%. At the same time management are continuing to deliver cost out initiatives to offset the impact of higher fuel costs.

As the domestic market leader in a rational duopoly we believe Qantas is well placed to raise ticket prices to offset the impact of higher future oil prices. At current valuations, trading on a price to earnings multiple of 9.4x vs global peers at 12x – in a more favourable industry structure – Qantas continues to represent a compelling high conviction investment in portfolios for our clients.

Amcor Ltd

Amcor is the global leader in flexible consumer packaging. One of the key raw material inputs into Amcor’s flexible packaging business is resin (plastic), which reached new highs in April 2018. However, Amcor has contractual raw material inflation pass through to its underlying customers. Over the short term, there is a lag of approximately 3-months to recover raw material cost increases. However, over the medium-term, Amcor is well placed to pass almost 100% of raw material cost inflation through to its underlying customers.

In August, Amcor announced the acquisition its largest competitor Bemis for US$6bn. Bemis enhances Amcor’s position by giving it a strong position in North America in addition to Amcor’s existing European and emerging market positions. The acquisition truly establishes Amcor as the global leader in packaging, able to offer global solutions. With a solid track record of generating value from acquisitions, good organic growth and a compelling valuation, Amcor is a high conviction position in the Firetrail portfolios that is well placed to navigate the current market environment.

Conclusion

Companies with exposure to raw material inflation will continue to see earnings pressure into FY19. As stock pickers, the key question we are asking ourselves is who are the winners and losers impacted by rising raw material costs?

In our view, investors should be wary of companies in highly competitive markets with a non-differentiated product, which may not be able to pass rising raw material costs on. Companies in market leading positions such as Qantas and Amcor who are able to pass higher costs onto their underlying customers will fare better in this environment. Businesses with strong earnings growth such as James Hardie, which has been sold-off heavily also represents a compelling long-term opportunity for our investors.

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Firetrail Investments Pty Limited ABN 98 622 377 913 (‘Firetrail’), Corporate Authorised Representative (No. 1261372) of Pinnacle Investment Management Limited ABN 66 109 659 109 AFSL 322140.

Any opinions or forecasts reflect the judgment and assumptions of Firetrail and its representatives on the basis of information at the date of publication and may later change without notice. Any projections contained in this article are estimates only and may not be realised in the future.  The information is not intended as a securities recommendation or statement of opinion intended to influence a person or persons in making a decision in relation to investment. This communication is for general information only. It has been prepared without taking account of any person’s objectives, financial situation or needs. Any persons relying on this information should obtain professional advice relevant to their particular circumstances, needs and investment objectives. Past performance is not a reliable indicator of future performance.

Interests in the Firetrail Absolute Return Fund (ARSN 624 135 879) and Firetrail Australian High Conviction Fund (ARSN 624 136 045) (‘Funds’) are issued by Pinnacle Fund Services Limited ABN 29 082 494 362 AFSL 238371. Pinnacle Fund Services Limited is not licensed to provide financial product advice. A copy of the most recent Product Disclosure Statement (‘PDS’) of the Funds can be located at www.firetrailinvest.com  You should consider the current PDS in its entirety and consult your financial adviser before making an investment decision.

Pinnacle Fund Services Limited and Firetrail believe the information contained in this communication is reliable, however its accuracy, reliability or completeness is not guaranteed and persons relying on this information do so at their own risk. Subject to any liability which cannot be excluded under the relevant laws, Firetrail and Pinnacle Fund Services Limited disclaim all liability to any person relying on the information contained in this communication in respect of any loss or damage (including consequential loss or damage), however caused, which may be suffered or arise directly or indirectly in respect of such information.

Diversifying your portfolio to weather market ‘down days’

Diversifying your portfolio to weather market ‘down days’

Patrick Hodgens, Managing Director & Portfolio Manager

Investors received a timely reminder yesterday that equity markets do not always rise. For only the second time this year the Australian equity market fell by more than 2% in a day, returning -2.7%. The only larger daily decline this year occurred on February 6 when the market fell -3.2%.

During the week the market has fallen -5%, whilst the Firetrail Absolute Return Strategy has delivered positive returns of 1.2%, outperforming the market by over +6%. When uncertainty and volatility begin to show themselves, adding a market neutral strategy to your portfolio can be a good way to diversify your returns to weather a market downturn.

With markets at all-time highs, we believe now is the time to add an uncorrelated source of returns like the Firetrail Absolute Return strategy to your investment portfolio.

The largest drawdowns over the past 20 years 

Equity markets can be volatile. Despite being a great investment over the long term, there have been significant drawdowns as highlighted in the chart below.

ASX largest drawdowns over the past 20 years

Source: Bloomberg

The largest drawdown was the Global Financial Crisis (GFC) when the Australian market fell over 50%. These significant falls can have a severe impact on your portfolio’s returns and can take a long time to recover from. The market took over five and a half years to recover from the lows of the GFC.

The key question investors may be asking is how do I avoid these significant market drawdowns?

Some investors try to time the market and move between equities and cash. However, in over 30 years investing in equity markets I am yet to come across an investor who can time the market with the accuracy and consistency required to add value.

One of the great investors of our time Peter Lynch sums market timing up wisely, “Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in corrections.”

Diversifying your portfolio to weather market ‘down days’

Rather than trying to anticipate the next market downturn, a far more prudent approach is to mix in a portfolio of uncorrelated assets that can weather different market environments. Adding alternative investments to a diversified portfolio is also a good way to hedge your portfolio’s exposure to equities and provide an alternative source of returns.

In our experience managing market-neutral strategies, you can diversify your portfolio for the ‘down days’ by adding alternative strategies to your portfolio that mitigate two key risks prevalent in equity market investing:

  1. Market risk – Reducing your portfolios net market exposure to zero at all times ensures portfolio returns are not affected by market movements
  2. Macroeconomic risk – Reducing your exposure to unpredictable macroeconomic risks such as interest rate movements, currency fluctuations or political decisions is key to reducing the volatility of your portfolio’s returns. Whether and when the China/US trade war is resolved or predicting interest rate rises are binary bets that can either significantly amplify or reduce portfolio returns. In our view, you need to reduce your exposure to these key risks and focus on investing in companies from a fundamental perspective, rather than unpredictable macroeconomic themes.

An alternative investment from Firetrail 

The Firetrail Absolute Return Strategy is a market-neutral, alternative investment strategy that invests in Australian shares but hedges its exposure to the underlying share market, with a portfolio of short positions that are equal to its long positions. It is designed to deliver returns that are uncorrelated to, or independent from, movements in the underlying share market.

The portfolio has a history of delivering uncorrelated returns, particularly during market drawdowns. As the chart below highlights, during the strategy’s full history, there have been 15 monthly market drawdowns shown in blue. Of these, the strategy (in green) has only has two drawdowns where the market was also negative. It is a true alternative source of returns uncorrelated to the underlying share market.

ASX 200 Monthly Drawdowns vs Firetrail Absolute Return Strategy Composite Returns

Past Performance is not a reliable indicator of future returns
Source:*Composite returns using Macquarie Pure Alpha Fund returns. Pro-rata adjusted to apply to current management fee of 1.5% to the performance history since July 2015. Combined with Firetrail Absolute Return Fund returns since inception on 14 March 2018. The Firetrail Absolute Return Fund employs the same investment approach as was used by the same investment team that managed the Macquarie Pure Alpha Fund until October 2017.

In a market that has fallen over -5% in a week, the Firetrail Absolute Return Strategy has delivered positive returns of +1.2%, outperforming the market by over +6%.  Over the past week we have benefited from a focus on fundamentals with long positions in defensive companies Amcor Limited, Northern Star and Woolworths which have all outperformed relative to the market. Importantly, the short portfolio has provided significant downside protection, delivering +0.3% of the total 1.2% outperformance during the week.

Conclusion – Now is the time to diversify your portfolio 

It can sometimes take a timely market correction to remind investors of the benefits of diversifying your portfolio. In particular, if you are looking to hedge some of your equity market exposure risk, the Firetrail Absolute Return strategy is an alternative investment strategy that stays truly market-neutral. Providing returns that are independent of the underlying share market and reducing your portfolio’s exposure to unpredictable macroeconomic risk.

With markets at all-time highs, and uncertainty and volatility beginning to show, we believe now is the time to add an uncorrelated source of returns like the Firetrail Absolute Return strategy to your investment portfolio.

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Firetrail Investments Pty Limited ABN 98 622 377 913 (‘Firetrail’), Corporate Authorised Representative (No. 1261372) of Pinnacle Investment Management Limited ABN 66 109 659 109 AFSL 322140.

Any opinions or forecasts reflect the judgment and assumptions of Firetrail and its representatives on the basis of information at the date of publication and may later change without notice. Any projections contained in this article are estimates only and may not be realised in the future.  The information is not intended as a securities recommendation or statement of opinion intended to influence a person or persons in making a decision in relation to investment. This communication is for general information only. It has been prepared without taking account of any person’s objectives, financial situation or needs. Any persons relying on this information should obtain professional advice relevant to their particular circumstances, needs and investment objectives. Past performance is not a reliable indicator of future performance.

Interests in the Firetrail Absolute Return Fund (ARSN 624 135 879) and Firetrail Australian High Conviction Fund (ARSN 624 136 045) (‘Funds’) are issued by Pinnacle Fund Services Limited ABN 29 082 494 362 AFSL 238371. Pinnacle Fund Services Limited is not licensed to provide financial product advice. A copy of the most recent Product Disclosure Statement (‘PDS’) of the Funds can be located at www.firetrailinvest.com  You should consider the current PDS in its entirety and consult your financial adviser before making an investment decision.

Pinnacle Fund Services Limited and Firetrail believe the information contained in this communication is reliable, however its accuracy, reliability or completeness is not guaranteed and persons relying on this information do so at their own risk. Subject to any liability which cannot be excluded under the relevant laws, Firetrail and Pinnacle Fund Services Limited disclaim all liability to any person relying on the information contained in this communication in respect of any loss or damage (including consequential loss or damage), however caused, which may be suffered or arise directly or indirectly in respect of such information.

Two golden shorting rules

Two golden shorting rules

James Miller, Portfolio Manager

Short selling shares aims to profit from share price declines. Short selling is a very different proposition to going long. Not only is your upside capped, and downside unlimited – but you also have a to pay a fee to borrow the stock. The easy answer can be to exclude shorting from your portfolio completely. However, at Firetrail Investments we believe there are significant benefits to be gained from shorting, and that investors should consider allocating a part of their portfolio to shorting.

In the article below we outline ways to obtain short exposure through managed funds in Australia, and also two of the golden rules that we follow at Firetrail when uncovering opportunities for stocks to short.

How do i get access to shorts in Australia?

When looking at managed funds, there are broadly two categories of funds that offer shorting. In our view, the most important decision that investors in these funds must make is the overall level of equity market exposure desired. The two categories are:

  1. Market exposed funds, or otherwise known as long short funds. These funds have a positive exposure to the equity market. The direction of the equity market is the best indicator of returns – if the equity market falls in absolute terms, then it is likely that these funds will have also fall. Common long short funds in Australia have 130% long equities, and 30% short equities – giving 100% equity market exposure.
  2. Market neutral funds are funds where exposure to the equity market has been minimised or eliminated. These funds, such as Firetrail Absolute Return, have short positions equal to their long positions meaning the equity market exposure has been minimised. Returns are not dependent on whether the market is up 20%, or down 20%, but instead by whether the manager has chosen the right stocks to buy long, and right stocks to sell short.

Whilst I have narrowed down the funds to these broad two categories – within the categories there are managers with different styles (value, growth, pairs trading etc).

Two golden rules we have on shorting

Shorting is the opposite to going long. It requires a different psychology when investing. Our experience in shorting has provided two key lessons that are applied when finding shorting opportunities.

1.     Ignore Valuation

Valuation can be a strong indicator signal to buy a stock as a long position. But it’s not so good on the short side! Stocks can remain expensive on valuation for long periods of time….and even get more expensive. Holding a short position in a stock that has a high valuation can be a dangerous investment proposition.

Take a look at the case of CSL over the past five years. It’s been a great performer – driven by not only earnings improvement, but also a significant increase in its valuation. This can be seen in the increase in the Price to Earnings Ratio from 20x to ~35x in the chart below:

Source: Factset

Under these circumstances it could be argued that CSL is expensive, and we do not necessarily disagree with this. But in our view, it will likely remain at its current level until we see a catalyst occur. In the short-term share prices tend to follow earnings, and a catalyst to short the stock would be if our research suggested that they would not meet market expectations. Currently this isn’t the case for us – and CSL isn’t a short position.

2.     Don’t hold on to shorts forever

“Time in the market, rather than timing the market” …….is not true for shorting!

Controlling your timeframe for shorting is critical – the longer you hold on to a short the higher the risk is that the share price will rise (and hurt your returns).  We advocate holding shorts for a shorter period of time than you would hold most of your long positions. Be opportunistic in looking for the catalysts.

A great example of the importance of managing a timeframe is the example of Spotless, which was the subject of a takeover offer from Downer in March 2017. Just 3 weeks earlier, Spotless had reported its first half 2017 financial results, which had resulted in brokers downgrading earnings forecasts by 20%. The share price fell 18% over two days, and over the next 3 weeks the short interest increased to 6% of the company. It was then that the takeover bid from Downer arrived – at a 60% premium to the price at the time. A painful day for the shorts!

Source: Bloomberg

Holding on to a short position after a catalyst has occurred, like the Spotless earnings downgrade, is the riskiest time to be short. Not only are company boards and management under immense pressure to improve earnings and the share price, but it is also a time where possible suitors could make a play for the company. Managing the timeframe for holding a short position is one way of minimising this risk.

Shorting is a valuable tool 

There is a different mindset required to short successfully. Not only can shorting be used to reduce levels of equity market exposure, but shorting can be a great contributor to returns in a portfolio when rules are followed.

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Firetrail Investments Pty Limited ABN 98 622 377 913 (‘Firetrail’), Corporate Authorised Representative (No. 1261372) of Pinnacle Investment Management Limited ABN 66 109 659 109 AFSL 322140.

Any opinions or forecasts reflect the judgment and assumptions of Firetrail and its representatives on the basis of information at the date of publication and may later change without notice. Any projections contained in this article are estimates only and may not be realised in the future.  The information is not intended as a securities recommendation or statement of opinion intended to influence a person or persons in making a decision in relation to investment. This communication is for general information only. It has been prepared without taking account of any person’s objectives, financial situation or needs. Any persons relying on this information should obtain professional advice relevant to their particular circumstances, needs and investment objectives. Past performance is not a reliable indicator of future performance.

Interests in the Firetrail Absolute Return Fund (ARSN 624 135 879) and Firetrail Australian High Conviction Fund (ARSN 624 136 045) (‘Funds’) are issued by Pinnacle Fund Services Limited ABN 29 082 494 362 AFSL 238371. Pinnacle Fund Services Limited is not licensed to provide financial product advice. A copy of the most recent Product Disclosure Statement (‘PDS’) of the Funds can be located at www.firetrailinvest.com  You should consider the current PDS in its entirety and consult your financial adviser before making an investment decision.

Pinnacle Fund Services Limited and Firetrail believe the information contained in this communication is reliable, however its accuracy, reliability or completeness is not guaranteed and persons relying on this information do so at their own risk. Subject to any liability which cannot be excluded under the relevant laws, Firetrail and Pinnacle Fund Services Limited disclaim all liability to any person relying on the information contained in this communication in respect of any loss or damage (including consequential loss or damage), however caused, which may be suffered or arise directly or indirectly in respect of such information.

Three reasons shorting can benefit your investment returns

Three reasons shorting can benefit your investment returns

James Miller, Portfolio Manager

Most investors place their bets on share prices rising. There is a lot less focus placed on shorting, the betting that share prices will decline. Shorting is done by borrowing shares for a small fee, selling them on the market, and then buying those shares back at a later date. With shorting a profit is made if the share price declines during your holding period.

Currently in the Australian equity market just 2% of the bets being made are short bets. To put this in context the dollar value of Australian shorting is $29b. A big number, but tiny when compared with the ASX200 market cap value of $1.86 trillion.

Looking at the US equity market, the level of shorts is 6% of the market.  In this context of global developed equity markets, Australia is a relatively underpenetrated shorting market. Firetrail Investments believe that there is not only significant alpha that can be found by shorting stocks in Australia, but also that there are plenty of opportunities for this shorting.

1. Shorting opportunities are abundant 

Even in strong years for the Australian equity market, there are many stocks that fall. The ASX200 price index rose 8.3% in the year to 30 June 2018 – not a bad return! But as can be seen in the table below – the variation of returns across the market was significant:

Source: Firetrail, Bloomberg

In the year to June 2018 there were 95 stocks that rose more than the market’s 8.3% return and 127 stocks that rose in absolute terms. But what is most interesting is those 73 stocks that fell. These are the stocks that would have generated you a return from shorting.

Understanding the reasons for these stocks falling is the first step in understanding how to pick stocks to short.

2. There are risks, but shorting can also be rewarding

Shorting can be risky, and it is by no means a “set and forget” strategy. Losses are unlimited, and your maximum upside is 100%. So why even bother shorting?

The reason shorting can be attractive is that whilst over long periods of time most stocks and equity markets rise, in the short term the story is very different. Changes in expectations will drive changes in share prices in the short term. We believe there are two catalysts that cause stocks to fall in the short term:

  • The first reason is that current earnings expectations are not met. An example of this is Asaleo Care (AHY), a tissue manufacturer, which fell 49% during the month of July 2018. The company released a trading update to the market which pointed out rising input costs and increasing competition were affecting profitability. Average 2018 broker earnings forecasts for the stock fell 42% after this announcement.
  • Secondly, future earnings expectations may be downgraded. This can typically be from a change in market share, a new competitor entering an industry, or loss of a contract.  Whilst earnings expectations in the short term may be met, future earnings estimates will be reduced. In our experience share prices typically capitalise this future loss immediately.  Sigma Healthcare (SIG), a distributor to Australian pharmacies, announced in July that it had lost its largest customer Chemist Warehouse. This resulted in no change in the current year’s earnings – but a whopping 53% earnings downgrade for FY21. The stock fell 40% on the day this was announced.

Source: Firetrail, Factset

The way to pick these catalysts is through fundamental research of individual companies and an understanding of the industries that they operate in. Once the earnings catalyst is identified, timing is then critical.  If we think a stock will downgrade current earnings when they announce earnings in August, we will be short for the August announcement. Holding on to short positions for long periods of time increases your risk of positive share price movement – for example from a takeover.

3. Shorting requires a different mind-set

As opposed to investing long, we believe valuation is not a great indicator for shorting opportunities. You need to put valuation aside when you are shorting.

Just because a stock might screen “expensive”, it doesn’t mean it is a great short opportunity. Domino’s Pizza (DMP) was arguably expensive in 2013 when it was trading at a one year forward Price to Earnings ratio of 25x. But 3 years later it was at a 55x Price to Earnings ratio. Domino’s Pizza did eventually fall, but it was due to current earnings expectations not being met.

Rather than focusing on valuation, we believe the focus should be on earnings expectations. If our research suggests that earnings expectations, either current or future, will not be met, the stock can be a short candidate.

Summary: Shorting can be a valuable addition to your portfolio 

Shorting opportunities are abundant – every year there are stocks that fall, despite the return of the overall market. By researching and identifying the catalysts for these stock declines, shorting can be a significant contributor to alpha in your portfolio. The key is to understand the risks versus the rewards when shorting and acknowledging that shorting is very different to investing long!

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Firetrail Investments Pty Limited ABN 98 622 377 913 (‘Firetrail’), Corporate Authorised Representative (No. 1261372) of Pinnacle Investment Management Limited ABN 66 109 659 109 AFSL 322140.

Any opinions or forecasts reflect the judgment and assumptions of Firetrail and its representatives on the basis of information at the date of publication and may later change without notice. Any projections contained in this article are estimates only and may not be realised in the future.  The information is not intended as a securities recommendation or statement of opinion intended to influence a person or persons in making a decision in relation to investment. This communication is for general information only. It has been prepared without taking account of any person’s objectives, financial situation or needs. Any persons relying on this information should obtain professional advice relevant to their particular circumstances, needs and investment objectives. Past performance is not a reliable indicator of future performance.

Interests in the Firetrail Absolute Return Fund (ARSN 624 135 879) and Firetrail Australian High Conviction Fund (ARSN 624 136 045) (‘Funds’) are issued by Pinnacle Fund Services Limited ABN 29 082 494 362 AFSL 238371. Pinnacle Fund Services Limited is not licensed to provide financial product advice. A copy of the most recent Product Disclosure Statement (‘PDS’) of the Funds can be located at www.firetrailinvest.com  You should consider the current PDS in its entirety and consult your financial adviser before making an investment decision.

Pinnacle Fund Services Limited and Firetrail believe the information contained in this communication is reliable, however its accuracy, reliability or completeness is not guaranteed and persons relying on this information do so at their own risk. Subject to any liability which cannot be excluded under the relevant laws, Firetrail and Pinnacle Fund Services Limited disclaim all liability to any person relying on the information contained in this communication in respect of any loss or damage (including consequential loss or damage), however caused, which may be suffered or arise directly or indirectly in respect of such information.